Oh SNAP!

SNAP Inc., owner of the budding social media platform snapchat, has announced plans to go public capturing the imagination of investors following a year of abysmal technology IPOs in 2016.

With plans to raise an estimated $3 billion from its IPO, market observers estimate that the Company will fetch a valuation of $20 to $25 billion, a healthy premium to its most recent valuation of $18 billion as a private company. According to Dealogic, 26 technology IPOs in 2016 raised $4.3 billion from US exchanges.

Echoing the IPO behaviour of other technology firms, SNAP founders Even Spiegel, 26, and Bobby Murphy, 28, plan to implement a multiple class structure. But unlike their tech peers, they plan to issue shares to the public with zero voting rights, which is considered extreme even by technology industry standards. Google founders Sergey Brin and Larry Page gave themselves disproportionate voting power back during their 2004 IPO allowing them to control almost 60% of voting rights. Mark Zuckerberg of Facebook followed suit in 2012 only to strip investors of their voting rights last year in order to maintain 60% of voting rights while donating substantially all of his shares to his foundation.

Voting power

SNAP has created a three-tiered share structure.

The company boasts just over 512 million Class A shares, which carry zero voting rights. The founders each hold 21.8% of these shares. Early investors Benchmark Capital Partners and Lightspeed Venture Partners hold 12.7% and 8.3% of these shares respectively with SNAP board member and Benchmark general partner Mitchell Lasky holding a further 12.7%.

Class B shares carry 1 vote per share and are primarily owned by the aforementioned venture capital funds: Benchmark (22.8%), Lightspeed (15%), and Lasky (22.8%). Atop the share hierarchy are Class C shares which are equally owned by Spiegel and Murphy and each boast 10 votes per share effectively giving the young founders 88.6% of voting rights.

Post-IPO, each Class B share transferred will automatically convert to a Class A shares save for a few exceptions. Additionally, Class C shares will convert to Class B shares upon transfer save for a few exceptions, which include the transfer of shares between the founders themselves. Both Class B and Class C shares convert to Class A and Class B shares, respectively upon the death of the holder. Moreover, should one of the founder’s holding of Class C shares fall below 30% of his holding at the time of the IPO or a specific number of shares to be later determined, said shares would automatically convert to Class B shares. And when there are no Class C shares left, outstanding Class B shares will convert to Class A shares, all of which would gain voting power to the tune of 1 vote per share.

Figure 1: SNAP major shareholders prior to IPO

Source: S-1 SEC filing

A cursory review of the holdings would reveal that the SNAP founders each enjoy a control premium of almost 2.29 times. In our previous reporting, we defined control premium as voting power as multiple of actual economic interest. A control premium in excess of 1 violates the “one-share/one-vote” principle and enables a concentrated group of shareholders to control the firm.

In a report co-authored by IRRC and ISS, researchers found that controlled firms with single class structures outperformed their counterparts with multiple class structures in the S&P 1500 Composite Index over a 3-year, 5-year, and 10-year performance period ending in August 2012. However, multiple class structures did outperform over a 1-year period[i]. In analysing SEC disclosures between 1990 and 1998, Chad Zutter of the University of Pittsburgh found a substantial discount applied to the initial valuation of dual class structures. He interpreted it as the market’s perception of “a relationship between the extreme entrenchment of dual-class management and firm performance” and concluded that the market tends to overprice said structures around the time of the IPO only to correct as time passes[ii]. These findings seem to broadly confirm the conclusions derived from the IRRC/ISS report.

Interestingly, other researchers have adopted a more nuanced view.Thomas Chemmanur and Yawen Jiao’s IPO model revealed that dual class IPOs are more likely to outperform their single class peers when "the reputation of the incumbent is high and the firm is operating in an industry where the difference in intrinsic values between the projects with high and low near term uncertainty is large"[iii]. Whether Spiegel and Murphy the true visionaries they are trumpeted up to be is yet to be determined, but the technology sector does offer its fair share of uncertainty and astronomical valuations.

Disenfranchisement did not seem to deter investors in the technology sector in the past, but have the SNAP founders gone too far? In a recent letter to Spiegel, Murphy, and chairman-designate Michael Lynton, the 18 members of the Council of Institutional Investors (CII), which include the California Public Employees Retirement System (CalPERS) and Aberdeen Asset Management, urged SNAP to adopt a single class share structure citing the findings in the IRRC study[iv].

The Corporate Governance Principles for US Listed Companies championed by the Investor Stewardship Group (ISG), a grouping of 16 US and international institutional investors which include Blackrock and Vanguard, has also publicly rebuked dual class structures. The second concisely echoes this sentiment: “Shareholders should be entitled to voting rights in proportion to their economic interest”. It further calls for boards that currently employ dual class structures to regularly review the benefits of such a practice and to “establish mechanisms to end or phase out controlling structures at the appropriate time, while minimizing costs to shareholders”. Although the ISG does not plan to uphold these principles until January 1, 2018, their message is loud and clear[v].

Expensive valuation

Talk of SNAP’s valuation has gripped markets. Although an IPO price has yet to be disclosed, analysts are estimating a valuation of $20-$25 billion, a multiple of 62 times FY 2016 sales or 25 times FY 2017 projected revenues. A very expensive proposition compared to the valuations used for some of its peers such as Facebook and Twitter.

Making this generous valuation even more worrisome is the fact that SNAP reported a gross margin of almost -12% for FY 2016 (although margins turned to a positive 7% in Q4 2016). These abysmal margins are due to the fact that, unlike Facebook and Twitter, SNAP outsources its data services to the Google Cloud. Earlier in the year, SNAP signed a 5-year deal with the Google Cloud Platform that requires a minimum payment of $400 million/year to provide the infrastructure vital to keep its Snapchat application running. Twitter, at a similar revenue base, boasted gross margins of 63%[vi]

Other profitability measures do not paint a prettier picture. Adjusted EBITDA worsened by 57% to reach -$459 million in FY 2016 and the Company continues to haemorrhage cash flow, reporting Free Cash Flow of -$678 million, almost double its cash loss in the prior year period. It is no surprise then that SNAP’s valuation is predicated on the anticipation of stellar revenue growth going forward, with estimates that they would reach $1 billion in FY 2017 vs. $405 million last year. Nevertheless, growth in Daily Active Users (DAU) appears to be losing steam, reporting year-on-year growth of 40% in Q4 2016, down from a peak of 65% growth in Q2 2016. Even quarterly DAU growth has fallen to the single digits in the last two quarters of FY 2016. Analysts have not overlooked the potential for Facebook’s “Instagram Stories” to accelerate this trend.

Shareholders should also note that Twitter, trading currently at $18-$19/share, is still almost 50% below its IPO valuation and market observers are sceptical as to whether it can generate the growth necessary to justify a higher valuation. Facebook, after debuting in a disastrous IPO which shed over 50% of its value, has come roaring back, currently trading at 350% of its IPO price, after it definitively proved its staying power.

The stakes are evidently high, and given the extremely volatile nature of young technology companies, it is incumbent upon boards to at the very least give shareholders a say in how their companies are run.

Executive Compensation

Our discussion then turns to executive compensation, where it appears that SNAP executives are being generously compensated for their potential to generate future growth as opposed to actual performance.

Figure 3: SNAP executive compensation in FY 2016 and FY 2015.

Source: S-1 SEC filing

Evan Spiegel, who currently serves as CEO collected $2.4 million in compensation in FY 2016 and received no shares as compensation. However, shareholders should note that the Class A shares he received as a dividend for his holdings are excluded from these figures.

The Company has stated that post-IPO, Spiegel will receive a symbolic salary of $1, mirroring that of Mark Zuckerberg and the Google founders. Nevertheless, he is slated to receive an award of 3% of all outstanding shares on the closing of the IPO, or should the valuations being floated be realized, a handsome $600 to $750 million windfall. The award will be paid in the form of Class C shares, making Spiegel the largest controlling shareholder, pushing him well ahead of Murphy in the pecking order.

Last year SNAP made headlines when it poached Imran Khan from Credit Suisse to be its chief strategist, rewarding him with 7 million restricted share units (RSUs) worth an astounding $146 million. Almost all share awards (RSUs and stock options) have a service condition (time spent at the company) and a performance condition. According to the S1 filing, the performance condition is ‘satisfied on the occurrence of a qualifying event, which includes a change in control or the effective date of an initial public offering’.

As of December 31, 2016, SNAP had almost $1.5 billion in employee RSUs that have not yet satisfied the service condition. More troublingly, had the IPO occurred on December 31, 2016, SNAP would have recognized a colossal $1.1 billion in compensation for RSUs that have already satisfied the service condition. The most recent RSUs granted in November-December 2016 boasted a weighted average fair value of $16.33/share. As for stock options granted during the year, the weighted average fair value was $30.19/share, with a strike price of $1/shares. In July 2016, 1,253,028 stock options were granted with an underlying common stock fair value of $31.08/share.

A successful IPO will prove to be an enormous payday for SNAP executives, and given the lack of genuine performance conditions, they may not bear the consequences should a massive correction in the share price take hold à la Twitter.

Much ado about nothing?

If SNAP were to become the next Facebook, dissenting voices will surely be silenced as institutional investors reap the benefits of a higher share price. On the flipside, investors stand to lose quite a bit and will not have the power to change how the Company is being run.

Proxinvest is seriously concerned by the unabashed subversion of shareholder rights at the expense of power-hoarding visionaries, the venture capitalists who enable them, and the opportunistic bankers who hype them. No promise of potential short-term profits should replace shareholder democracy and reasonable valuations.

The question investors have to therefore contemplate is whether accepting excessive non-performance based remuneration and a dual class structure that marginalizes them, is truly worth the risk of investing in SNAP? Time alone will tell.

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